Advanced Credit Risk Management Revised CCP Notes

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This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her to evaluate and manage credit portfolio risk using the proven tools and methods and advise management regarding optimal credit portfolio and credit risk diversification.



A candidate who passes this paper should be able to:

  • Apply the principles of credit portfolio risk management in identification, measurement and management of major credit portfolio risks
  • Relate firm risks to portfolio risks and capital adequacy.
  • Mitigate credit exposure using various securities in covering credit obligations exposure.
  • Advise the management regarding the optimal lending, product-wise, for a profitable credit portfolio (Credit portfolio risk vs. Return).
  • Employ risk diversification, trading of credit assets and credit derivatives in mitigating credit portfolio risk.
  • Establish and implement the organization’s overall credit risk management plan.



Introduction to Credit Portfolio Management (CPM)

  • Credit portfolio vs. Equity portfolio (Criticality of Credit Portfolio Risks)
  • Benefits of credit portfolio management
  • Role of credit portfolio management: Credit department; – veto rights, advisory or profit Centre
  • Portfolio management strategies – Passive Vs Active CPM
  • Portfolio analysis
  • Challenges of implementation of Active Credit portfolio management
  • Credit portfolio risk vs. Return


Major portfolio risks

  • Systematic Risk (triggers and consequences)
  • Diversifiable risk
  • Concentration risk
  • Credit portfolio beta
  • Measuring credit portfolio risk


Credit Risk in Working Capital

  • Working capital cycle (Lenders’ point of view)
  • Working capital vs. Fixed capital
  • Working capital financing
  • Working capital ratios
  • Working capital behavior
  • Working capital risks (Overtrading, diversion, inflation and contingencies) and their impact
  • Working capital risks mitigations


Credit Risk in Project Finance

  • Overview of project finance (features and types of project finance)
  • Phases of projects and risks
  • Project credit risks
  • Financial study (cash flow forecasts, economic worth and credit worthiness)
  • Mitigating project credit risks


Firm Risks to Portfolio Risks and Capital Adequacy

  • Obligor probability of default (PD) and portfolio probability of default
  • Default risk (Firm level defaults and portfolio defaults)
  • Loss given default (LGD) and expected loss (EL)
  • Provisioning (firm level and portfolio-level)
  • Credit loss distribution
  • Economic Capital (measurement and optimisation)


Credit Risk Pricing

  • Credit pricing factors
  • The pricing structure
  • Origination of credit risk
  • Credit risk pricing models
  • Prime lending rates (Base rate and KBRR)
  • Pricing methods (RORAC, NPV, RANPV)


Credit Risk Modelling

  • Introduction to Credit Portfolio Models.
  • Basic statistics for risk management: Volatility, correlation, VaR, Monte Carlo simulation, Copula functions in modelling default correlation.
  • Merton Model, Moody’s KMV, Credit Metrics, One-period Portfolio Models, Gaussian Models etc
  • Alternative modelling approaches: Default models and mark to market / multi-state models, Structural and reduced form models
  • Conditional and unconditional models
  • Scenario and sensitivity analysis in CPM


Credit Risk and the Basal Accords and Prudential Guidelines in Lending

  • Regulatory framework
  • Basal I and its criticism
  • Alternative approaches for credit risk in Basal II
  • Risk Weighted Assets and Capital adequacy (Basal vs. Prudential Guidelines)
  • Criticism of Basal II
  • Credit risk measurement and management under Basal III
  • Basal III and prevention of future financial/credit crises
  • Managing nonperforming assets/loans under prudential guidelines (CBK)
  • IFRS 9 and management of accounts receivables
  • Towards Basel IV: Rationale and Regulatory compliance enhancement proposals


Credit Portfolio Risk Mitigation

  • Credit risk diversification (traditional and modern diversification)
  • Trading of credit assets
  • Credit derivatives
  • Credit Insurance
  • Best practices and principles of credit portfolio management as per the International Association of Credit Portfolio Managers (IACPM) framework


Collateral Management

  • Security basics overview (need, attributes, types and pricing)
  • Methods of taking security and perfection of securities
  • Covenants (financial and nonfinancial)
  • Realising security
  • Credit risk management planning and strategy


Credit Portfolio Management and Credit Crisis

  • Road to credit crisis (role of banks, formation of credit bubbles, credit bubble explosion)
  • 2008 Credit crisis (causes and consequences)
  • Lessons of the 2008 credit crisis


Analysis of Case Studies

Practical business scenarios on credit exposure management – entity level exposures and portfolio credit exposures and credit risk management planning


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The modern day credit executive – banker, finance manager, financier, for example – cannot do justice to their profession unless they know Portfolio Credit Risks. Ignoring portfolio credit risks can have catastrophic impact, even resulting in bankruptcies. The failure of many banks and financial institutions across the world can often be traced also to poor credit portfolios. The credit portfolio is critical to all business enterprises having sizeable credit exposures. Most modern day businesses cannot exist without a credit portfolio. Proper understanding of credit portfolio risk is a key success factor in enterprises with significant credit assets.


Most of the portfolio management techniques evolved in the equity arena first, and were then adapted by other areas like commodities, foreign exchange and credit markets. Portfolio management techniques such as portfolio theorem, swaps, options, etc. are some of the prominent examples. Large financial institutions are devoting considerable resources to developing new models for portfolio management. With advances in technology, the efforts of many brilliant researchers in large financial institutions, and the accumulation of significant bodies of knowledge on credit experience and analysis, credit portfolio management tools are likely to become more sophisticated in years to come. Since portfolio techniques have mostly originated in the context of equity, it is better to make the distinction between equity portfolio and credit portfolio and proceed. The major similarities are (i) that credit and equity are two popular forms of capital and (ii) that both portfolios are impacted by both systematic and unsystematic risks.

The major differences are given below:

  1. Whilst concentration of the equity portfolio in a few names may be an acceptable risk, such action is not recommended for the credit portfolio. As we will see later in the book every effort must be made to avoid any sort of concentration in a credit portfolio. The reason is that, unlike the equity portfolio, concentration is expensive for credit portfolios because of the small upside and large downside risk. Hence, wide diversification is a must in a credit portfolio.
  2. Divergent risk/reward pattern. The return (interest, commission charges, etc.) on a credit portfolio is fixed while that of the equity portfolio is unlimited depending upon the profits generated. The equity can participate in the entire profits after meeting other obligations. Hence, the probability of substantial returns exists in the equity portfolio, which is not the case with a credit portfolio.
  3. Credit enjoys a prior claim on the assets of the business. In the case of secured credit the priority increases and enjoys higher ranking as far as repayment of principal and interest is concerned. However, the equity holder will get their principal back only after satisfying all creditors. Equity has the lowest ranking in the event of liquidation of the business.



We have seen details about the individual firm credit risk and its components under the External, Industry, Internal and Financial (EIIF) risks model and how to evaluate them. Now it is time to focus on portfolio risks. While firm-level credit risk analysis attempts to establish the creditworthiness at obligor level, credit portfolio risk analysis focuses on a broader approach to credit risks and studies the credit risk behaviour of homogenous groups of obligors/credit assets.

No one can manage a credit portfolio efficiently unless the underlying portfolio credit risks are known. Portfolio management requires detailed knowledge not only of obligor credit risk exposures, but also portfolio specific risks. The portfolio perspective allows the credit risk management to adopt a top-down approach and understand the key drivers impacting the portfolio risk profile. Amongst others, it answers following questions:

  1. Which are the correlated sectors within the portfolio?
  2. Is there any concentration risk in the portfolio? If so, how can it be managed down?
  3. What are the risky areas in the portfolio, in view of the changes in macroeconomic environment?
  4. How much credit risk can the institution absorb?
  5. Does it have adequate capital to take such a level of portfolio risk?
  6. Which types of credit risks should the institution avoid?
  7. What are the credit risks the institution is willing to underwrite?

These are all critical questions for the survival of an institution and proper answers are available only from the study of portfolio risks. Having understood the portfolio risks, appropriate risk mitigation measures can be taken to minimize the portfolio risks.


The study and examination of credit assets from the portfolio perspective is highly useful. Consequently, many enterprises, especially financial institutions, are increasingly measuring and managing the portfolio credit risks. The main benefits of credit portfolio risk analysis are given below.

1 Active Credit Portfolio Management

Credit assets are nowadays amenable to proactive management. Instead of holding the credit assets till maturity, they can be offloaded or sold during the intermediate period. Syndicated loans can be sold to other participants or a newcomer while the availability of credit derivatives and securitization has opened new doors for active credit portfolio management.2 Assuming the credit risk of two assets is the same, if the low-return asset can swapped for a higher-return asset, then the credit portfolio’s return will improve with no addition to risk. For all credit sub-portfolios with a given level of risk, the lender will select the one with the highest return. To take advantage of such opportunities, the following portfolio level questions are important:

  1. What is the portfolio risk – before and after the intended transaction?
  2. How does the change in portfolio mix impact the risk level?
  3. In the changing environment, which credit assets are to be bought and sold?

One of the major benefits of a portfolio approach to credit risk management is its active management, which will enhance return and possibly reduce the overall credit risk. This type of portfolio level decision presupposes sound understanding of various portfolio dynamics.

2 Overall Credit Risk Reduction

The aggregation of all firm credit risks in a portfolio does not equal portfolio risk. In fact, proper risk management can reduce the portfolio risk below the total or average of firm credit risks. Whilst EIIF credit analysis looks at individual credit, increasing global/regional pressures, including competition among others, demanded a broader view of credit risk resulting in the portfolio approach. Firm credit risk, can be classified into different grades, denoted by alpha-numerals such as AAA, A1, BBB, B1, B2 etc. Unlike firm credit risk, portfolio credit risk is also impacted by certain other factors such as distribution of the credit exposures among industry, region, etc. The fundamental concept is roughly explained by the following example:

Example 13.1

A financial institution (or a large multi-product manufacturing company) has a portfolio of 100 credit customers enjoying short-term credit facilities. After strict credit assessment, the firm credit risk of all 100 obligors/customers is graded as ‘medium’. What would be the portfolio credit risk in the following scenarios?

  1. All concentrated in the same region/locality.
  2. All from the same cyclical industry.
  3. The portfolio is equally distributed between two different regions or countries separated by 2,500 km distance.
  4. The portfolio is equally distributed among three different industry segments that are not related to each other.
  5. The portfolio is equally distributed among different ten different regions or countries and from ten unrelated industries.



Although all 100 customers are of acceptable credit quality, from a portfolio credit risk perspective scenarios (1) and (2) imply higher portfolio credit risk with (5) being the least risky. The other two cases lie in between. More discussion on portfolio risks is taken up in later chapters.

The distribution, composition and dispersion of the portfolio components have significantly different ramifications as is evident from the dissimilar portfolio credit risks under the different circumstances mentioned above. Covariance or correlation of firm credit risks has a significant impact at portfolio level, which is one of the key topics in credit risk study at portfolio level. A clear idea about the aggregate behaviour of varying categories of credit assets and their overall impact on the portfolio is critical.


3 Optimizes Liquidity

Take the balance sheet of any bank or financial intermediary or any large business enterprise. A sizeable debtors/credit portfolio is a usual feature in most balance sheets. Liquidation of the receivables/debtors portfolio is a major source of cash flows to meet various commitments. Better liquidity is ensured by proper handling of the credit portfolio, which calls for understanding of portfolio credit risks.

This is critical if the credit assets are leveraged – viz. created with a significant amount of external obligations. This is most important for banks and financial institutions, where the lenders themselves are borrowers with high levels of leverage. An unexpected drop/deterioration of portfolio quality has destabilized, decapitalized and destroyed lenders. In the case of a credit crisis, a liquidity crunch is almost inevitable, especially if the underlying credit portfolio lacks quality. For example, during the 2008 Credit Crisis, several banks, finance companies, insurers, investment banks and lessors faced a liquidity crunch.

Banks create credit assets out of deposits from public or from inter-bank borrowings, all of which have contractual obligations. It results in an inevitable link between the solvency, maturity profile and quality of credit assets. The study of portfolio credit risks for assessing liquidity of a bank/financial institution/enterprise has become a necessity rather than an option.

4 Assists Sales and Marketing

The credit department, through portfolio analysis, can help Sales and Marketing understand where the best opportunities may exist to grow the business. Constant measuring and monitoring of portfolio risk not only ensures that the aggregate risk is managed within an acceptable range, but also influences portfolio composition/business development decisions. For example, if the sales team targets 25% growth of its current customer base, the portfolio manager can furnish valuable information on how the resulting credit exposure can be achieved with minimal increase in portfolio risk.

The opportunity to take on a slightly greater risk at ‘firm’ level becomes acceptable if the ‘portfolio’ risk (viz. overall risk pool) stays within an acceptable tolerance level. As the need to capture more markets in the face of increasing competition continues, the portfolio perspective attains more importance.

5 Insights into Sectoral Risk Exposures

Different sectors and industries in an economy display dissimilar behaviour patterns due to a wide range of factors. As we discussed in Chapters 5 and 6, the business cycles, external risks and industry risk affect the obligors. A large number of obligors in a portfolio is of no consolation, if the portfolio suffers over-exposure to shaky industries. It is too risky, as the obligors will definitely be impacted by a downturn in that industry, which would turn satisfactory firm credit risks into unsatisfactory ones, within a short span of time, impacting the portfolio.

It is well accepted that the overall credit risk changes with evolving changes in the macro economy. Hence, the credit portfolio risk ought to be understood in the context of possible impact to the various portfolio components in the face of changes, such as cyclical upturns and downturns, political risks, interest rate movements, tariff changes, global developments, foreign exchange fluctuations and so on.

These factors and prior bad debt experience will guide the portfolio managers to identify vulnerable sectors and accordingly certain industrial and economic sectors of the portfolio ought to be designated as high risk. In such instances, it is necessary to establish separate policies and procedures to limit/restrict the extent of such portfolio exposures.

6 Solves the Capital Dilemma

It is now becoming accepted that the quantum of capital should be linked to the risks undertaken, especially in banks and financial institutions. A bank balance sheet reflects its financial condition. Assets are the income-producing assets, e.g. loans. Liabilities like deposits and inter-bank borrowings along with the equity capital fund the assets. By definition, the capital of the bank equals assets minus liabilities. In banking, the term ‘capital’ is used instead of ‘tangible net worth’, which is usually used in accounting. These terms are synonyms.

Example 13.2

The following are simple balance sheets of two banks of identical size. Highly leveraged Bank A and low-leveraged Bank B have a total asset base of $1,000m. Both suffered a credit loss of $125m. However, the impact is very different. The details are given below:

In the case of Bank A, the capital is negative, which shows insolvency – i.e. the capital has fallen below zero. The bank’s assets are not enough to repay its depositors. As it is insolvent, it would have to cease operations, unless recapitalized or bailed out by another healthier institution or the government. On the other hand Bank B continues to be solvent and can continue its operations. It is evident that high leverage is a risk. Since banks operate on thin margins (mainly the difference in margins between deposits and loans), in order to create value for shareholders, some amount of leverage is a must (i.e. unavoidable in banking business). Bank regulators, who are concerned about the cascading impact of bank failures on the overall economy, tend to prefer more capital (i.e. less leverage than the bank management, who prefer more leverage to add more value to shareholders). Accordingly, the bank regulators usually prescribe a minimum level of capital to be maintained by banks and financial institutions, which is the basis of ‘Regulatory Capital’ concept in the Basel Accords.

The credit portfolio has a critical role to play when deciding the amount of capital to be held by a bank. Accordingly, if a business enterprise wishes to pursue higher credit risks, a higher capital cushion is called for. This is especially true for banks and financial intermediaries, who are active in credit markets. Capital is relevant from a risk management perspective because it is a measure of owners’ funds at risk in the business, which is expected to provide an incentive towards good governance as well. Calculation of the ‘risk based capital requirement’ is done in two ways:


Regulatory Capital: The central banks all over the world welcome more capital in banks’ capital structure and have prescribed a minimum requirement in this respect, which is commonly known as Capital Adequacy Ratio/Regulatory Capital under the Basel Accords. The minimum level of regulatory capital is stipulated at 8% of the risk portfolio. We will discuss more about it later in Chapter 15. To put it briefly, regulatory capital aims at ensuring adequate resources available to absorb the losses. The higher the credit risk of the credit portfolio, the higher the capital required. Accordingly, a financial intermediary that comes under some kind of capital regulatory requirement ought to reduce the proportion of high risk credit exposures in the portfolio if it does not wish to maintain a higher level of capital.


Economic Capital: Economic capital is decided by each bank’s (organization’s) own internal plans. The calculation of economic capital is stated to be more scientific than regulatory capital as it focuses on prudent behaviour from the point of view of a single institution. Regulatory capital is put in place to ensure the stability of the banking system as a whole, rather than what constitutes prudent behaviour from the point of view of any single institution. Economic capital, which can be more or less than the regulatory capital, is usually calculated by statistical methods and is based on historical experience. Given its complexity, economic capital is computed only by sophisticated financial institutions, which are able to deploy resources towards advanced techniques. (Please see Chapter 15 for more elaborate discussion.)


7 Portfolio Management Strategies

A credit portfolio is a bunch of credit assets of different risk grades, belonging to different regions or countries and probably scattered among different industry/economic sectors. Against the backdrop of the macroeconomic environment and capital constraints, the portfolio manager ought to determine portfolio strategies such that the portfolio risk does not spiral out of control. Such strategies will provide preparedness to face all uncertainties through the construction of a balanced portfolio. This includes the study of the impact on portfolio credit risks due to changes in portfolio mix or external stimuli.

One of the unique advantages of the portfolio approach is the ability to identify where the potential of enhanced returns lies. For instance, business enterprises with well-defined portfolios having detailed sub-portfolio classifications (such as industry, region and customer sub-segments etc.), find it easy to identify which sub-portfolios provide the best credit returns. The portfolio managers in turn can devise strategies to realize the full potential of each sub-portfolio.

Another advantage of the portfolio approach is that appropriate risk management strategies can be devised. Hence many financial institutions invest resources to develop and implement sophisticated portfolio approaches to manage the credit risk. Awareness of portfolio risks enables identification, monitoring and control of risk concentrations and correlations, on an ongoing basis. Periodical review of the credit portfolio is to be undertaken, to consider portfolio risks such as:

  • Growth or contraction in credit portfolio size.
  • Vulnerability to any major external stimuli.
  • Industry/borrower concentrations.
  • Credit grade movements.
  • Adequacy of provision for doubtful credit assets.
  • Derivative exposures.
  • Other related or current credit issues.


We believe that heavy concentrations in a credit portfolio are best avoided, however a few authorities consider industry concentrations to be a plus, arguing that specialization promotes better quality loans by developing the bank’s expertise in a few industries. We believe that this is an inherently risky proposition because heavy concentrations in industries cause problems, especially during a general economic slowdown or downturn specific to those industries where risk is concentrated. However, at the same time over-diversification must be avoided – i.e. in the zeal for diversity, expansion into industries or geographies where the lending institution lacks experience and expertise may bring in challenges increasing the credit risk.

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